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Loss Aversion: What Ben Franklin Can Teach Us About Trading

Last updated 5/25/2012 12:49 PM EST (GMT -5) 1 Comments

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Matthew Weller

Technical Analyst, GFT

You’ve probably heard Benjamin Franklin’s famous proverb “a penny saved is a penny earned.”

What most people don’t realize is that Franklin never actually said the words “a penny saved is a penny earned . ”  In reality, the famous adage is an adaption of Franklin’s true quote: “a penny saved is twopence dear.” While this may seem like a relatively minor detail, the true quote is another example of Franklin’s folksy wisdom being centuries ahead of his time.

Franklin’s words articulate an inherent human shortcoming that has only been described and quantified in the past 25 years: people do not consider a loss as equal to a gain of the same magnitude. In fact, researchers (Tversky & Kahneman, 1991, p. 1053) have found that the pain of losing (or not "saving”) money is twice as strong as the joy of gaining the same amount of money , the precise ratio that Franklin observed nearly 250 years ago. The imbalance of emotions between making and losing money leads to a cognitive bias called Loss Aversion .

In trading more than any other endeavor, Loss Aversion can lead to a number of incredibly harmful tendencies:

1) “Getting Back to Break Even”

The most common way traders are affected by loss aversion is through a nagging temptation to “get back to break even” before exiting a losing trade. Traders want to avoid being “wrong” in their analysis, arguing that “a loss is not a loss until the trade is closed”. Many even increase their position size so that they can get back to break even sooner. In general, these habits do more harm than good, leading to substantial losses on relatively few trades that can overwhelm dozens of profitable trades. This is why Paul Tudor Jones, one of the greatest traders of all time, has always kept a note reading “LOSERS AVERAGE LOSERS” posted above his trading computer.

2) Changing the Reason or Timeframe for a Trade

 Another symptom of loss aversion is the tendency to change the reason or timeframe for a trade when the initial thesis does not play out as expected. A trader may enter a long position based on a moving average crossover, for example, but when the pair fails to rally to the target, he will remain in the trade, rationalizing that “the MACD is still showing bullish momentum” or “the upcoming GDP report will probably lead to a rally.” He might even widen out the stop loss or delete it entirely as he continues to rationalize the trade. Typically, these “explanations” are just ways to avoid the pain of losing a trade. As a general rule, traders should never alter the reason for a trade or change the timeframe because the trade is not working out in the anticipated time period. 

3) Prematurely Tightening Stops

The last common way that Loss Aversion can hurt traders occurs when a trader looks to quickly tighten the stop loss on a winning trade in an effort to "lock in" profits or reduce the risk of loss on a trade. Many traders go through this stage at one point in their development, and while this strategy sounds relatively harmless, it can still have a subtle, insidious negative effect on profitability. When taken to an extreme, traders who give in to this tendency end up with many breakeven trades, a few winners (that go straight to the target), and a few more losers (when the trades never go into a profit). While it may feel good to tighten the stop on a trade, traders should always determine whether they are doing so because of the price action or because they want to avoid the pain of a losing trade.

Managing the Effect of Loss Aversion on Trading

As with many cognitive biases, one of the best ways to manage the impact of Loss Aversion on your own trading is simply to be cognizant of it. Know that you may be tempted to use one of three crutches outlined above, and evaluate whether you are interpreting the information objectively, or merely acting on the emotional urge to avoid taking losses. Realize that the market will go where it’s going regardless of your trade; it doesn’t know or care where you got into your position or whether you are currently in a profit or a loss.

Taking the above one step further, most successful traders have developed a specific trading plan with detailed risk management rules to take emotional decision-making out of their hands (for more on trading plans, see my colleague Brad Gareiss’ articles “Creating a Trading Plan” and “Following the Plan” ). Ideally, your trading plan will specify exactly when it is prudent to adjust a stop loss or position size. At a minimum, many traders would likely benefit from a few hard and fast rules, such as “Always use a stop loss” and “Never double down on a losing position.”

Finally, understand that even the best traders have losing trades - after all, if we knew which trades would be successful, we would never place the losing trades!. In most cases, the best course of action is to take a quick loss on the trade that isn’t working out and move on to the next opportunity. 

Not for the first (or last) time, Benjamin Franklin’s homespun wisdom remains relevant today. The next time you’re considering a trade that is currently unprofitable, remember that from a psychological perspective, a penny saved is actually worth two pennies earned.

For more on trading psychology, as well as intraday analysis and trading ideas, follow me on twitter (@MwellerFX) and attend GFT’s daily Live Market Analysis webinars. Visit your local GFT website under “Getting Started” for more details and to register.

Tversky, A. & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference Dependent Model. The Quarterly Journal of Economics, 106(4), 1039-1061. Retrieved from http://www.econ.brown.edu/fac/Kfir_Eliaz/LossAversionRisklessChoice.pdf

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Comments (1)

katavatso

February 11, 2012 at 04:05 PM ET

thanks

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